Financial System in the Modern Economy - Assignment Example

Module Financial System. The financial system plays a really important role in the modern economy. No economy can function without having areliable and stable financial system. It is basically an auxiliary setup that supports the monetary transaction of people and channels the funds in the economy. The financial system is an economy circulates the money in a way which is considered desirable for the growth and prosperity of the economy. It basically consists of three important parts. These parts include Financial Institutions, Financial Intermediaries, and Financial Markets and Financial Instruments (Mishkin and Eakins). All of these parts are closes dependent on each other. A good financial system makes sure that all these parts function together to make sure that the money is optimally channeled in an economy. If one part of the financial system is in conflict with the other, or if there is a distortion between the motives of the two parts of a financial system, then there are chances that the financial system will collapse. This is very dangerous for the entire economy, because when one part of financial system collapses, other parts also face the domino effect causing the economy to face serious recession and plummeting demand. Hence, it is imperative for an economy to have a stable financial system if it is to work well. (Mishkin) Financial markets make it possible for people to trade securities. It is a good way of raising capital, transferring risk, liquidity maintenance and trading foreign exchange. The financial markets play an important role in instilling level of confidence in the investors. They know that they can invest now and liquidate in future when they need funds and allow them earn interest on their money. Examples of Financial Markets can be Stock Markets, Money Markets, Forex Markets and IPOs (Lipsey and Chrystal). A good financial system usually contains financial markets as a platform that allows the trading of financial securities and instruments. Similarly, Financial Institutions consist of those organizations that allow channeling of funds and create credit in the economy. In case these are missing in a financial system, then the economy is deprived of multiplier effect and can face serious levels of unemployment and lack of investment motives. Examples of Financial Markets include Banks, Building Societies, Leasing Companies etc. Financial Instruments are securities that are traded in the Financial Markets. These include bonds, stock, money market securities and derivatives. These are again very important because they are used in trading of debt, liquidation and transfer of risk. If these instruments are missing in a financial system then there will be lots of hassle in carrying out smooth operations in the financial system (Amadeo). Hence, many countries these days are coming up with hybrid instruments to make sure that the functioning of the financial system is not only smooth but also safe. Financial intermediaries play an important role of channeling funds in the financial system between surplus and deficit agent. An example of a financial intermediary can be a bank that plays an important role in creating credit in the economy. (Pillbeam) Financial systems are highly mechanized and efficient systems. They came into being after years of improvement and constant changes in the ways it was run. However, still no one can claim that the perfect financial system has been developed especially after the 2008 financial crisis. However, work is being done and new developments are taking place in the financial system and we can safely presume that it is not long before we will reach our destiny and develop a very good financial system that would try to avoid all risks and provide perfect liquidity and returns to the investors without any flaws that are present in the current financial system. (Valdez) One important part of the modern financial system is Banks. They play a very important role in all the modern financial systems. One cannot imagine a financial system where this important part is missing. Like heart pumps blood to all parts of the economy, banks are used to pump money to different part of the economy. If banks are not present in the financial system then many parts of the economy that need funds would be deprived of them and they will suffer a condition of stroke. This can be very dangerous since all the parts or sectors in an economy are closely related. If even one part is not functioning correctly then there are chances that the entire financial system and the whole economy would collapse. This is a dangerous proposition and hence banks were developed by the financial systems through the world to make sure that these conditions do not exist and that money is being pumped to the entire economy and all its parts. Similarly, banks play another important role in channel funds between the deficit and surplus agents. The channeling of funds is known as credit creation. Many people have excess funds or money that won’t be used. Since, money is losing its purchasing power they need to earn interest on it to make sure that they are par with the inflation. Similarly, there are people who are in an immediate need of cash. They need it so dearly that they are ready to pay interest on it. Hence, banks take money from people who fear that it will lose its purchasing power and channel it to people who need it. This fulfills the aims of both segments of the societies and leads to efficient and smooth functioning of the economy. In the recent times banks were blamed for the financial crises. Banks sometimes can get really casual and can lend money without taking the required proof of income or collateral. This is called sub-prime lending. This can lead to loss of funds because in time sub-prime borrowers find out that they cannot pay their debts and file for bankruptcy. This implies loss of funds for the banks and dichotomy in the financial system. This tells us that if the banks are not cautious in their dealing then the whole financial system is at the risk of collapsing. (Healy) Works Cited: Amadeo, Kimberly. US ECONOMY: RECESSIONARY PERIODS. Retrieved on 6 August 2011. http://useconomy.about.com/od/grossdomesticproduct/a/recession_histo.htm Healy, Jack. US home sales remain sluggish. NY TIMES. Retrieved on 18 August 2011. http://www.nytimes.com/2009/05/28/business/economy/28econ.html?_r=1&emc=et Lipsey,R and Chrystal, A. Economics. 10th Edition. Oxford City: Oxford University Press. 2003 Mishkin, Fredric and Eaking, Stanley. Financial Markets and Institutions. Addison Wesley. 2008 Mishkin. F. Economics of Money, Banking, Financial Markets and Business Schools. Addison Wesley. 2009 Pilbeam, Keith. Finance and Financial Markets. New York: PALGRAVE MACMILLAN, 2005. Valdez, Steven. An Introduction to Global Financial Markets. Macmillan Press, 2007 US Department of State. Retrieved 20 June 2011, from: http://www.state.gov/r/pa/ei/bgn/3208.htm Read More